IRP Relationship. Assume that interest rate parity (IRP) exists. Assume this inf
ID: 2739200 • Letter: I
Question
IRP Relationship. Assume that interest rate parity (IRP) exists. Assume this information provided by today’s Wall Street Journal: Spot rate of Swiss franc = $.80. 6-month forward rate of Swiss franc = $.78. 12-month forward rate of Swiss franc = $.81. Assume that the annualized U.S. interest rate is 7 percent for a 6-month maturity and a 12-month maturity. Do you think the Swiss interest rate for a 6-month maturity is greater than, equal to, or less than the U.S. interest rate for a 6-month maturity? Explain.
Explanation / Answer
Answer :Since the 6-month forward rate contains a discount(2.5%), the Swiss 6-month interest rate must be higher than the U.S. 6-month interest rate as depreciation in forward exange rate will be offset by the higher interest rate.
Discount =(.80-.78)/.08*100 =2.5%
Explanation:
If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency.
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